Chapter EMC, Problem 1FRQ

a)

To determine

To state: Whether the situation reflects moral hazard or adverse selection along with the solution to reduce the inefficiency that arises.

Answer to Problem 1FRQ

The correct answer is adverse selection.

Explanation of Solution

When consumers buy a second-hand car without knowing it’s a high-quality car or low-quality car, the seller knows about it. This is a case of adverse selection.

Adverse selection happens when one person is familiar with more about the way things are than other people. Adverse selection exists, for example, when sellers propose items of mainly low quality for sale, and when people with an extreme need for insurance are almost certain to buy it.

So, the solution to reduce the inefficiency, in this case, is that the seller could offer a warranty with the car that pays for repair costs.

Economics Concept Introduction

Introduction:

Adverse selection happens when one person is familiar with more about the way things are than other people. Adverse selection exists, for example, when sellers propose items of mainly low quality for sale, and when people with an extreme need for insurance are almost certain to buy it.

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.

b)

To determine

To state: whether the situation reflects moral hazard or adverse selection along with the solution to reduce the inefficiency that arises.

Answer to Problem 1FRQ

The correct answer is Moral hazard.

Explanation of Solution

In the case where the consumer with dental insurance might not brush their teeth, knowing that if they get cavities, insurance will pay for the filling, this is a situation of moral hazard.

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.

So, the solution to reduce the inefficiency, in this case, is that each insured person can be made to pay a co-payment of a certain dollar amount each time they get a filling.

Economics Concept Introduction

Introduction:

Adverse selection happens when one person is familiar with more about the way things are than other people. Adverse selection exists, for example, when sellers propose items of mainly low quality for sale, and when people with an extreme need for insurance are almost certain to buy it.

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.

c)

To determine

To state: whether the situation reflects moral hazard or adverse selection along with the solution to reduce the inefficiency that arises.

Answer to Problem 1FRQ

The correct answer is Moral hazard.

Explanation of Solution

In the case where the company does not know whether the individual worker on an assembly line is working hard or slacking off, this is a situation of moral hazard.

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care. '

So, the solution to reduce the inefficiency, in this case, is by compensating the workers on a piece rate basis, that is, pay as per how much production has been made by an individual worker each day.

Economics Concept Introduction

Introduction:

Adverse selection happens when one person is familiar with more about the way things are than other people. Adverse selection exists, for example, when sellers propose items of mainly low quality for sale, and when people with an extreme need for insurance are almost certain to buy it.

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.

d)

To determine

To state: whether the situation reflects moral hazard or adverse selection along with the solution to reduce the inefficiency that arises.

Answer to Problem 1FRQ

The correct answer is Adverse selection.

Explanation of Solution

In the case where the company/ prospective employer does not know whether the individual worker is productive or not, this is a situation of adverse selection.

Adverse selection happens when one person is familiar with more about the way things are than other people. Adverse selection exists, for example, when sellers propose items of mainly low quality for sale, and when people with an extreme need for insurance are almost certain to buy it.

So, the solution to reduce the inefficiency, in this case, is by providing the prospective employers with references from former employers.

Economics Concept Introduction

Introduction:

Adverse selection happens when one person is familiar with more about the way things are than other people. Adverse selection exists, for example, when sellers propose items of mainly low quality for sale, and when people with an extreme need for insurance are almost certain to buy it.

Moral hazard rises when individuals have more knowledge about their actions than others. This results in the falsification of incentives to apply or to take care of effort when someone else tolerates the costs of the lack of effort or care.